Emerging Markets

Highlights Our net assessment of India is bullish over the long run, but this year is full of risks. Prime Minister Modi will struggle to reboot the economy and maintain social stability in his second term. If unemployment, social unrest, and communal tensions spiral out of control, Modi could lose political capital. A foreign policy blunder with China and Pakistan would also weaken Modi’s strongman image. Losses for Modi and the BJP would weigh on India’s potential growth and earnings outlook. Buy Indian stocks on dips, but monitor risks. Go long Indian pharma and local currency government bonds. Feature The Indo-Chinese conflict on the Himalayan border is unlikely to have a significant impact on global financial markets. A major escalation could cause short-term volatility. But most likely an escalation will have a regional impact and present a buying opportunity for Indian, Chinese, or Pakistani equities. There is a potential problem for India, however, in the combination of internal and external political risks. Prime Minister Narendra Modi faces a threat to his popular support because of the economic shock of the COVID-19 pandemic. Insufficient fiscal stimulus will lead to a faltering recovery. Lingering large-scale unemployment will motivate social unrest. Thus Modi will struggle to ensure economic recovery and law and order in his second term. Our base case is that he has the political capital and enough time on the political clock to stabilize the country and his rule. However, a failure to handle domestic challenges poses a risk to our view. And a foreign policy defeat at the hands of the Chinese would further undermine our view. Over the past two months we have written about the risk of social unrest and political instability in emerging markets due to the global pandemic. In this report we extend that analysis to India. We are strategically bullish on India. But a fundamental loss of control by Modi’s administration would skew the risk to the downside over the near and medium term. India’s Domestic Risks India is neither the worst nor the best off among emerging markets. It ranks right in the middle of our COVID-19 Social Unrest Index, mostly because of the status of the economy (Table 1). Table 1Our COVID-19 Social Unrest Index For Emerging Markets Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 1India's Economic Pain A Challenge For Modi India's Economic Pain A Challenge For Modi India's Economic Pain A Challenge For Modi Given that Chile, Russia, and China rank at the top our list, and yet face challenges to their stability, India’s middling position should not be interpreted optimistically. The economic hit has been massive. Manufacturing and especially services PMIs collapsed in April and May, pulling down the composite index to 7.2 and 14.8 respectively, from 50.6 in March – just a hair above the 50 boom-bust line (Chart 1). The breakdown in manufacturing is one of the worst among India’s emerging market peers (Chart 2). This is a problem for a country that is trying to upgrade its manufacturing sector. The domestic economy was frail even prior to COVID. Growth slowed to 4.2% in 2019 from 6.1% in 2018. Discretionary spending by households, reflected in passenger car sales, and capital expenditure by companies were already extremely weak (Chart 3). Chart 2India's Manufacturing Hit Harder Than Other EMs India's Manufacturing Hit Harder Than Other EMs India's Manufacturing Hit Harder Than Other EMs Chart 3India's Consumers And Businesses In Freefall India's Consumers And Businesses In Freefall India's Consumers And Businesses In Freefall Exports have slowed since 2018 due to the Chinese slowdown and trade war (Chart 4). COVID-19 dashed the small signs of a rebound in early 2020. India runs a twin deficit and its fiscal position is especially precarious. At 7.4% of GDP in 2019, the general government deficit was among the largest going into the pandemic. Coupled with a high debt-to-GDP ratio, fiscal policy is a risk to India’s long run sustainability and foreign investors’ returns (Chart 5). This marks a major limitation on India’s ability to stimulate aggregate demand. Chart 4Consumer-Led, But Not Immune To Global Shock Consumer-Led, But Not Immune To Global Shock Consumer-Led, But Not Immune To Global Shock Chart 5Debt Constraint On Stimulus Debt Constraint On Stimulus Debt Constraint On Stimulus On the positive side, India’s foreign currency reserves are sufficient, and it is capable of repaying the foreign debt obligations coming due in the near term, according to our Emerging Markets Strategy (Chart 6). Thus while it has less fiscal space than some other emerging markets, it is not as exposed to a foreign funding squeeze. Chart 6AIndia Can Cover Foreign Debt Payments Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 6BIndia Not Over-Reliant On Foreign Capital Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? How large is India’s stimulus package? The headline-grabbing INR 20 trillion stimulus package – equivalent to 10% of GDP – overstates the direct stimulus to the economy (Table 2). Only about 1.3% of GDP consists of genuinely new on-budget spending. This is much bigger than the 0.5% of GDP fiscal stimulus in 2008-10 but smaller than what other major countries have done in the pandemic thus far (Chart 7). Table 2India’s Fiscal And Monetary Stimulus Amid Coronavirus Crisis Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 7India’s Stimulus: Larger Than GFC, But Smaller Than Many Peers Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Modi will likely need to unleash more stimulus, but his response thus far indicates that he recognizes the country’s fiscal constraints and is not throwing everything at the economy all at once. The COVID-19 crisis hit not long after Modi reconsolidated power in parliament. He has the political capital to make tough decisions – he is not forced to stimulate the economy frantically for the sake of general elections.1 Thus the administration is unlikely to take the path of fiscal profligacy. This is positive for the debt outlook, although it is negative for the demand outlook and recovery. Structural reform is a cornerstone of Modi’s stimulus package. Finance minister Nirmala Sitharaman has highlighted changes to land, labor, and law as parts of the stimulus package, as well as more typical measures to stimulate demand. For Modi the COVID-19 crisis and stimulus measures provide an opportunity to get reforms back on track after several initiatives, such as land reform, were put on hold in order to concentrate on the single biggest reform initiative of his first term (the goods and services tax). This reform agenda cannot go too far as Modi will be forced to sacrifice painful reforms for the sake of maintaining stability. But as long as India snaps back from its lockdown period like other economies, its decision to keep a lid on spending will enable it to manage inflation and generate savings and capital investment over the long run. This is what India needs to reform its moribund economy. Modi can also cut red tape and bureaucracy to speed the recovery. Bottom Line: Indian policymakers recognize the constraints of large deficits and debt and have thus far shown a reluctance to deploy massive fiscal stimulus. The upside is that India will avoid crowding out private investment that is essential to maintain its economic rise. The downside is a slower recovery. India Re-Opening, But Pandemic Yet To Peak On the pandemic, the good news is that India is experiencing a relatively low number of COVID-19 cases and deaths compared to Brazil and South Africa (Chart 8). This may be due to the early and stringent lockdown, the relatively small elderly share of the population, or other epidemiological factors. India also lags in terms of testing (Chart 9). Chart 8COVID-19 Still Poses A Risk Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 9India’s COVID Testing Has Lagged Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? However, any surge would devastate India’s weak health care system. The fact that the economy is reopening without having already experienced a peak in new cases bodes ill. What’s more, India does not appear to be in control of the virus’s spread. By contrast, the number of new cases is still rising in India three months after the nationwide lockdown was first imposed. Indians are vulnerable to the virus as they are more susceptible to die from major diseases than many other countries. India spends notoriously little on health. The health care infrastructure is in no shape to withstand a surge in infections. Reports indicate that even at current low COVID-19 infection rates, hospitals are already turning down patients due to a shortage of beds and ventilators. The implication is that India is not prepared to handle an outbreak that reaches levels seen in say Brazil, South Africa, or Turkey. Given that it is already loosening the lockdown without having witnessed a peak in cases, there is a risk that India has yet to experience the worst of the pandemic. Bottom Line: The pandemic has so far been relatively manageable in India. However, cases are still on the rise and are at risk of surging as the nationwide lockdown is eased. India’s poor health infrastructure puts the nation in a weak situation in handling the virus. Even if the virus itself proves overblown, Prime Minister Modi’s political capital could suffer from the health care crisis. The Risk Of Social Unrest Assuming that India muddles through the pandemic, Modi’s next big challenge is large-scale unemployment. Official unemployment figures – which are not published regularly – understate the impact of the deteriorating economic situation on households, as does our COVID-19 Unrest Index. Our index shows that Indian households, relative to EM peers, are not particularly distressed as measured by a combination of the Gini index of inequality and the “misery index” of unemployment and inflation (see Table 1). However, these are real problems for Indians themselves. Especially unemployment. The massive informal sector makes it hard to measure the real employment situation (Chart 10). Informal workers are the most vulnerable and face the greatest uncertainty. Chart 10India’s Informal Sector Masks Real Unemployment Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 11Household Income Shock Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 12Job Rolls Shrink For Traders And Workers Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Data from April, before reopening, show that nearly half of households saw a drop in income, according to the Centre for Monitoring Indian Economy (CMIE) (Chart 11). But the lifting of lockdowns is starting to bring down unemployment which peaked in May at nearly 25%, with small traders and laborers suffering the brunt of the layoffs (Chart 12). Individuals working in this category, along with farmers, are the most likely to be considered part of the informal sector. The improvement in unemployment also overlooks the decline in labor force participation, which fell to 38.7% in May from 43.2% before the pandemic. Therefore while economic reopening is undoubtedly positive for the labor market, the data do not capture the full extent of the impact of the pandemic and recession on household incomes. Moreover, the labor market may not revert to its pre-pandemic status quickly. Despite record unemployment, construction companies – a cornerstone of the Indian economy – were reporting difficulty in accessing labor in late-April when unemployment was at its peak, weighing on their ability to resume work.2 This is because migrants – which account for 20% of the labor force – are reluctant to return to work as they have been traumatized by the lockdown experience during which restrictions on travel left them stranded far away from their families and hometowns. Even though the restrictions have since been eased, many of the migrant workers are choosing to return home rather than take up work in the construction sector. Moreover, on June 9 the Supreme Court ordered states to transport all stranded migrant workers home within 15 days. The court’s request that federal and state governments ensure they are providing employment to migrants will help reduce unemployment among migrants. However, the unemployment rate is likely to stay high due to transitional unemployment. A lesser challenge comes from the collapse of oil-dependent Persian Gulf economies. Overall, remittances account for 3% of India’s GDP, which is substantial. Many of these workers are now jobless and India is repatriating its citizens that are stranded in the Gulf. An estimated 8.5 million Indians work there, which is small relative to the ~519 million strong domestic labor force. But the return of laborers may have an impact in certain regions. For example, the finance minister of Kerala noted they expect 500,000 Indians to return to his state, which could prove destabilizing. Modi’s biggest challenge is unemployment. Bottom Line: The easing of lockdowns has been positive for the jobs market. However, unemployment will be slow to recover to pre-COVID levels. India will face greater household grievances, threatening social unrest. This is a risk to Modi’s political capital over his second term. Communal Tensions Will Worsen Another risk to Modi’s political capital is the rise of communal tensions. These could potentially mobilize the political opposition against Modi, beginning at the state level. They could also lead to a secular rise in domestic insecurity, which would deter foreign investment. Religious polarization is picking up. India’s COVID lockdown brought a halt to anti-government demonstrations which started in December 2019 in protest of the Citizenship Amendment Act. Prior to the lockdown, many Indians had taken to the streets arguing that this act discriminated against the Muslim minority, violated the country’s foundational secular values, and was unconstitutional. Indian views on the law differ according to religion, with 63.5% of Muslims opposing the Act vs. 32.3% of non-Muslims (Chart 13). Chart 13Muslim Minority Opposes Citizenship Law Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? By granting citizenship to illegal migrants who entered India prior to 2014 from Afghanistan, Bangladesh and Pakistan, and who are Hindu, Sikh, Jain, Parsi, Buddhist, or Christian, Modi’s act used religion as a basis for citizenship, discriminating against the Muslim minority – which makes up almost 15% of India’s population. Although the demonstrations have paused, protesters’ grievances and the Citizenship Law itself remain unresolved. If anything, religious tensions intensified during the lockdown period, as police have been arresting high-profile activists. Right-wing groups have accused the Muslim community of being “super spreaders,” and pro-government media highlighted that regions with large populations of Muslims following the Tablighi Jamaat group have more COVID-19 cases.3 For example, these groups spread rumors that Muslim food vendors were intentionally spitting on fruits to spread the virus. They distributed flags to Hindu food vendors to make them more identifiable. Religious polarization and Modi’s suppression of the Muslim community will continue to be a source of instability throughout Modi’s second term. The prime minister’s stance regarding the minority group will not change. Rather, the weak economy will force Modi to seek success elsewhere, including through sectarian rhetoric to fire up his Hindu nationalist political base. Widespread unemployment will stoke these animosities. Thus religious and ideological tensions are likely to pick up rather than die down, resulting in communal violence and even radicalization and terrorism. This point is especially relevant in Muslim-majority Jammu and Kashmir, which is seeing a spike in communal tensions as well as an escalating struggle over the central government’s authority. Modi’s August 2019 decision to revoke the constitutional autonomy of Jammu and Kashmir also increases security risks. While the Indian government justified the move by the need to stop militancy in Kashmir, it is perceived by many Kashmiri Muslims as an attempt to tighten the government’s grip on the region and suppress their interests. The government’s moves in late 2019, which included a lockdown on the citizens of Kashmir, an internet blackout, and the arrest of local politicians and public figures, will provoke dissent, resistance, separatism, and radicalization. Fresh anti-India protests have already arisen in Indian Kashmir after the killing of nine rebels at the hands of Indian forces. The killings followed intelligence received by the Indian government that some of the rebels either wanted Kashmir to be independent or to merge with Muslim-majority Pakistan. According to a tally by the police, 73 rebels have been killed in Indian-administered Kashmir so far this year. New tensions could arise if India encroaches on Pakistan-administered Kashmir or if Pakistan-backed proxy groups strike out against India’s change of Kashmir’s status. This could lead to a more open-ended military confrontation between India and Pakistan than the tit-for-tat attacks in early 2019. The latter incident could be contained due to a novice government in Pakistan and the approaching general election in India, whereas a new round of hostilities might not so easily be dampened. Tensions with Pakistan are already high – two Pakistani embassy officials were expelled by New Delhi on May 31 due to allegations of spying. An India-Pakistan standoff could easily mingle with Sino-Indian tensions given China’s strengthening alliance with Pakistan. India accuses the People’s Liberation Army of assisting Pakistan on its side of Kashmir. A major escalation with China over Ladakh could entangle Pakistan and widen the conflict. Bottom Line: Religious polarization is picking up amid the lockdown and could explode as containment efforts are eased. India is likely to experience an intensification of unrest from the Muslim minority. In addition to being frustrated by the economy, this group is being politically marginalized, and thus will become more restless and radicalized over time. Will Modi’s Popularity Persist? Modi remains extremely popular, but he has seen his pandemic popularity “bounce” come and go (Chart 14). He is credited for the early and aggressive response to the outbreak, but his approval rating may have trouble in the coming months and years as the economic aftermath unfolds. The positives for Modi are very clear. India’s economic woes this year will be blamed on the shock brought on by the pandemic even though the economy was in bad shape prior to that, washing away any bad memories from the country’s de-monetization and implementation of the new goods and services tax. Another positive for Modi: while states led by his Bharatiya Janata Party (BJP) were previously worse off in terms of unemployment rates, this situation reversed in April and May. Now states led by the opposition Indian National Congress (INC) are suffering the greatest in terms of job losses (Chart 15). In fact, the average unemployment rate for states led by the BJP fell in May. Chart 14Modi’s Popularity High, But COVID Bounce Gone Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 15Opposition States Bear Brunt Of Unemployment Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? The dichotomy in state unemployment is due to the heavier presence of industry in BJP-led states such as Gujarat, Karnataka, and Haryana. The exodus of migrants from these states reduced the size of the labor force, bringing down unemployment rates. By contrast, unemployment spiked in migrant workers’ home states such as Jharkhand, and Punjab, which are opposition-led. Moreover there’s been little effective political opposition to Modi’s handling of the pandemic. True, as with all federal systems, Modi faces pushback from the state governments, which argue that their funding is drying up. A major source of state funding comes from alcohol sales, fuel, and real estate. The latter two have collapsed amid the recession, while the federal government’s decision to ban alcohol sales during the lockdown weighed on state financing and catalyzed the political clash. Yet Modi has used the occasion to centralize control and make his case for stronger federal government. For instance, he has mandated that only the central government can produce, procure, import, or distribute COVID-combating materials and equipment, from personal protective equipment (PPE) to masks to ventilators, thus clipping states’ powers. From a structural point of view, India needs a stronger central government to pursue economic and strategic objectives. Since the pandemic is a challenge that requires a strong central response, Modi’s centralizing approach continues to receive a tailwind from public support. India has a relatively strong score on our COVID-19 Unrest Index when it comes to governance, especially in terms of voice and accountability and control of corruption. Modi’s centralization of power could weaken governance over time, but it is not an immediate concern for investors since the overriding problem in India is a lack of national coordination.4 Clearly, then, the risk to Modi is that unemployment, unrest, communal tensions, and conflict with Pakistan and China lead to political defeats that deplete his political capital in his second term and make him vulnerable to electoral losses at the state level and ultimately in the general election in 2024. At the moment he has sufficient political capital, but political risks are much higher for him than they were prior to COVID-19. If these risks mount, Indian equities will suffer, as the clear implication is a loss of Modi’s and the BJP’s high level of control over both federal and state governments. This would reduce India’s ability to execute policy. The lack of coherence would shake investors’ faith in India’s ability to accelerate reforms and economic development. Bottom Line: Modi’s popularity enjoyed a solid bounce from the crisis and remains very high. He is concentrating power into the federal government, demonstrating that it is capable of rising to India’s modern challenges. The risk is that governance could suffer as a result of the massive challenges to the economy and social stability in the wake of COVID-19. Investment Takeaways Chart 16Indian Equities Breaking Down Indian Equities Breaking Down Indian Equities Breaking Down Indian equities relative to emerging markets are hovering at the 12-year moving average, a critical technical point. If they break beneath this level then there is further downside. Indian equities have broken down relative to global equities (Chart 16). The breakdown occurred despite the collapse in oil prices, which normally would help Indian stocks since the country’s import bill runs to 5% of GDP (Chart 17). Oil prices will strengthen in the second half of the year as global supply-demand balances tighten on the back of OPEC 2.0 supply restraints. Our Commodity & Energy Strategy expects cartel discipline to persist this year. A spike in oil prices driven by production cuts will penalize Indian stocks relative to EM peers. However, we maintain a bullish outlook on India over the long run and tend to view major selloffs, from today’s levels, as an opportunity to buy on the dip. Major selloffs from today are a buying opportunity. Specifically, we see a buying opportunity in Indian pharmaceutical equities (Chart 18). India is one of China’s top competitors in producing both active pharmaceutical ingredients and finished drugs for the United States. While India’s fiscal stimulus will incentivize foreign companies to move supply chains out of China, the United States’ upcoming rounds of stimulus will offer incentives for companies to move out of China, particularly health care companies. While the US rhetoric will emphasize “Buy American, Hire American” onshoring, economic constraints will still motivate companies to work abroad. It is China that will bear the brunt of US protectionist impulses, not the world as a whole. Therefore India stands to benefit, particularly when it comes to pharma. Chart 17Oil Price Drop Brought Cold Comfort This Time Oil Price Drop Brought Cold Comfort This Time Oil Price Drop Brought Cold Comfort This Time Chart 18Go Long India Pharma Versus EM Pharma Go Long India Pharma Versus EM Pharma Go Long India Pharma Versus EM Pharma We also recommend investors go long Indian local currency bonds relative to emerging markets. These bonds are protected by the fact that foreign ownership and capital outflows are limited, as Ayman Kawtharani of our Emerging Markets Strategy observes (Chart 19). Chart 19Go Long Indian Local Currency Government Bonds Go Long Indian Local Currency Government Bonds Go Long Indian Local Currency Government Bonds Chart 20Rupee Will Trend Sideways From Here Rupee Will Trend Sideways From Here Rupee Will Trend Sideways From Here Easier monetary policy will weigh on the rupee, but it is already near the floor of the narrowing band in which its been trading against the dollar since 2018 (Chart 20). Thus odds are that the currency will move sideways over the near term. The primary risk to our view is Modi’s political survival. A collapse of Modi’s political capital and momentum – for any reason – would not deliver a new prime minister or ruling party with the same degree of capital and momentum. Rather it would produce either a weak Modi and BJP, or a challenger that will likely lack Modi’s single-party federal majority and state-assembly majority. If unemployment, social unrest, and communal tensions evolve in a way that fundamentally undermines the Modi regime – if Modi and the BJP suffered permanent damage from this year’s crises – then India’s overall economic policy uncertainty would rise on a long-term basis. The market would have to downgrade India’s economic outlook and earnings expectations to adjust. We remain bullish India on a secular basis, however, because there would remain an underlying national consensus on the need to prioritize economic development. That will not change anytime soon, as Modi has demonstrated to the public and the opposition that it is a winning formula.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1 Upcoming state elections are a different story, but any stimulus will be local. 2 Pandya, Dhwani “Biggest Job Creator Short of Labor Amid Vast India Unemployment,” Bloomberg, May 6, 2020. 3 Muhammad Saad Khandalvi, leader of Tablighi Jamaat, has been charged with manslaughter after ignoring two notices to put a stop to an event hosted by the group at a mosque in New Delhi which started on March 3. The group claims to have ended the event prematurely upon learning of a national curfew on March 22, arguing that other non-Muslim religious gatherings are not facing the same charges. 4 The risk of centralization is that India’s governance could suffer over time. For example, the Prime Minister’s Citizen Assistance and Relief in Emergency Situations Fund, chaired by Modi, has been criticized for its lack of transparency and for diverting resources from other efforts. Modi created a new fund when an older fund, the Prime Minister’s National Relief Fund, already existed. Political patronage is clearly at work. Modi’s fund enjoys benefits that are unavailable to other relief funds, allowing overseas contributions and corporate donations to count toward the mandatory 2% of profits spent on corporate social responsibility.

Highlights When retail investors invest aggressively and central banks buy assets en masse, economic fundamentals take the back seat and momentum becomes king. Global risk assets are at a fork in the road: either they will relapse meaningfully as they have run well ahead of fundamentals or a budding mania will push global share prices to fresh new highs.   A budding mania is the basis behind our strategy of chasing momentum from this point on. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Feature Chart I-1Make It Or Break It Moment For US Dollar Make It Or Break It Moment For US Dollar Make It Or Break It Moment For US Dollar Global share prices have reached a point where they are no longer oversold. In turn, the trade-weighted US dollar has worked out its overbought conditions and is sitting on major defensive lines (Chart I-1). If the dollar relapses below its technical resistances, it will enter a bear market. Consistently, EM risk assets will enter a bull market. The trajectory of EM risk assets and currencies in the coming months will ultimately depend on what happens to the ongoing global FOMO (fear-of-missing-out) rally. We refer to it as a FOMO rally because both the DM and EM equity rallies have been taking place despite deteriorating corporate profit expectations, as we documented in our June 4 report. Why The FOMO Rally May Still Have Legs There are a number of reasons why this FOMO-driven rally could persist: Chart I-2Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US First, the Federal Reserve is explicitly targeting higher asset prices, and to achieve this goal it is deploying its “nuclear” arsenal – printing money and monetizing public debt, lending to the private sector as well as buying corporate bonds. US broad money growth is at an all-time high (Chart I-2). Consequently, the risk of a full-blown equity bubble formation in the US cannot be ruled out. If this occurs, all EM risk assets will rally along with the S&P 500. US policymakers are throwing everything into the system to keep financial asset prices inflated. It seems that after any day that the S&P 500 sells off, the Fed or the US administration comes up with some sort of new measure to support the economy and asset prices. Historically, investors have placed a lot of weight on the Fed’s actions. Aggressive measures by the Fed have recently led investors to purchase stocks and corporate bonds, irrespective of the condition of the underlying economy. As a result, share prices worldwide have decoupled from corporate profit expectations (Chart I-3A and I-3B). If US policymakers succeed in lifting US share prices further, every investor will likely chase the rally and the US equity market will become a full-scale bubble. Chart I-3AGlobal Stocks Are Pricing In A Lot Of Good News Global Stocks Are Pricing In A Lot Of Good News Global Stocks Are Pricing In A Lot Of Good News Chart I-3BSurging EM Share Prices Amid Plunging Forward EPS Surging EM Share Prices Amid Plunging Forward EPS Surging EM Share Prices Amid Plunging Forward EPS Chart I-4Retail Investors Have Driven Up Trading Volumes Retail Investors Have Driven Up Trading Volumes Retail Investors Have Driven Up Trading Volumes At some point, the bubble will start cracking even if corporate earnings find their way back to a recovery path. When equities make up a large share of investors’ assets, any trigger could lead to marginal sellers outnumbering marginal buyers. As we discuss below, there are plenty of risks that could result in a trigger. Both retail and institutional investors are very averse to losses, and when the market begins to slide, investors will sell their shares simultaneously. The market will plunge. The Fed will be forced to buy stocks to avert the negative impact of falling share prices on the economy. In a nutshell, US equities and corporate bonds have become extremely dependent on the Fed. This might be good news in the short and medium term. Nevertheless, it is negative for the US in the long run. Second, when retail investors rush into the market and actively trade, fundamentals take the back seat. This is what has been occurring since March. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks. This is illustrated by the surge in turnover volumes on the Nasdaq as well as in Southwest Airline, Norwegian Cruise Lines and Chesapeake Energy stocks (Chart I-4). Yet the impact of their actions is not limited to these stocks. Stocks are fungible. When retail investors purchase shares of near-bankrupt companies at elevated prices (at higher than fundamentals warrant), institutional investors sell those stocks and move capital to other companies. In aggregate, the stock market index rises.  The ongoing retail investor mania is not solely a US phenomenon. It has become prevalent in many other countries. There are anecdotes that Japanese retail investors have been actively trading Jasdaq stocks, while Korean, Taiwanese and Filipino retail investors have been buying local shares en masse.1  The top panel of Chart I-5 illustrates that Korean individual investors have been accumulating stocks while foreigners have been selling out. In Taiwan, the share of individual investors in equity trading has been rising at the expense of domestic institutional investors (Chart I-5, bottom panel). Retail investors do not do much fundamental analysis, and it should not come as a surprise that share prices have decoupled from their fundamentals (profits) and have gained despite lingering massive risks. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks.  Third, the mania phase – the last and most speculative stage – in bubble formation typically lasts between nine and 18 months. This is based on the duration of the mania phase in the Nikkei (1989), the NASDAQ (1999-2000), oil (2008) and Chinese A shares (2014-‘15) (Chart I-6). The retail investor-driven equity mania began in March and is now three months old. If the duration of previous manias is any guide, the current rally could last another six months at least. Chart I-5Strong Retail Buying Is Also Evident In Korea And Taiwan Strong Retail Buying Is Also Evident In Korea And Taiwan Strong Retail Buying Is Also Evident In Korea And Taiwan Chart I-6How Long Mania Phase Lasted During Previous Bubbles? How Long Mania Phase Lasted During Previous Bubbles? How Long Mania Phase Lasted During Previous Bubbles? Chart I-7China A-Share Bubble: A Divergence Between Stocks And EPS China A-Share Bubble: A Divergence Between Stocks And EPS China A-Share Bubble: A Divergence Between Stocks And EPS The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. Chart I-7 demonstrates that Chinese A-share prices skyrocketed in H1 2015, despite a deteriorating corporate profit picture. It lasted for a while and ended with a bust without any policy tightening taking place. Finally, retail investors are not quick to give up when they lose money. Having acquired a taste for capital gains over the past few months, retail investors will likely become even more aggressive and will keep buying the dips. In such a scenario, institutional and professional investors may be forced to capitulate and chase risk assets higher. We are at a fork in the road: either retail investors will begin reducing their equity holdings soon, or institutional and professional investors will capitulate and start buying en masse. In the first scenario, stocks will tumble as retail investors rapidly head for the exits. The latter scenario on the other hand will push share prices considerably higher. This is the basis behind our strategy of chasing momentum from this point on. Bottom Line: All financial market manias eventually crash. However, if the market breaks out, the rally could endure for several months. Not chasing the rally will be very painful for portfolio managers. This is why even though we believe the current global equity rally has been a FOMO-driven mania, we recommend to play it if EM share prices break above, and the broad-trade weighted dollar relapses below, current levels. Plenty Of (Disregarded) Risks Chart I-8Number Of New Inflections Is Rising In Large EM Countries Number Of New Inflections Is Rising In Large EM Countries Number Of New Inflections Is Rising In Large EM Countries Even though global risk assets have been rallying, the global investment landscape remains poor, with plenty of risks. In particular: Geopolitical tensions are bound to rise between the US and China. Taiwan and its semiconductor sector are at the epicenter of the US-China technological and geopolitical standoffs. Timing any escalation is tricky, but Taiwanese stocks are not pricing in these risks. Further, odds are high that North Korea will test a strategic weapon, which will undermine the credibility of President Trump’s foreign policy. This is negative for the KOSPI and the Korean won. An escalation in US-China tensions encompassing technology, Hong Kong, Taiwan and the Koreas is negative for equity markets in China, South Korea and Taiwan alike. Together they account for about 60% of the EM MSCI equity benchmark market cap. Moreover, the China-India skirmish is a risk for Indian stocks. The number of new Covid-19 infections is rising in the majority of EM countries excluding China, Korea and Taiwan as demonstrated in Chart I-8. It will be hard to ameliorate consumer and business confidence and thereby boost spending in these countries amid a worsening trend in the global pandemic. Indeed, a second wave of the coronavirus now hitting Beijing is evidence that even the very efficient Chinese system is not able to prevent pockets of renewed infection outbreaks. This risk still looms large over many advanced and developing nations after the first wave subsides. The post-lockdown natural snapback in economic activity is creating a mirage of a V-shaped recovery. Like any mirage, it can last and drive markets for a while. However, it will eventually fade. When that happens, misalignments in financial markets will be ironed out rather abruptly. A snapback in economic activity around the world is natural following the unwinding of strict lockdowns. Nevertheless, the level of business activity remains very low. Going forward, persistent social distancing, the threat of a second wave and an initial substantial income drawdown will cap the speed of recovery in household and business spending around the world. In our February 20 report titled EM: Growing Risk Of A Breakdown, we contended that the most likely trajectory for Chinese growth is the one demonstrated in Chart I-9. It assumed the plunge in business activity would be succeeded by a rather sharp snap-back due to pent-up demand. However, this snapback would likely be followed by weaker growth in the following months. This is also our roadmap for the business cycles of many DM and EM economies. Even though on May 28 we upgraded our economic outlook for Chinese growth from negative to mildly positive, near-term risks for China-related plays remain. Consistent with the trajectory described above, the Chinese economy has been coming back to life, aided in large part by significant credit and fiscal stimulus (Chart I-10, top and middle panel). Traditional infrastructure investment has accelerated strongly (Chart I-10, bottom panel). Chart I-9Our Roadmap For China’s Business Cycle EM: Follow The Momentum EM: Follow The Momentum Chart I-10China: Money/Credit And Infrastructure Are Accelerating China: Money/Credit And Infrastructure Are Accelerating China: Money/Credit And Infrastructure Are Accelerating   Consequently, mainland demand for commodities has been very robust and raw materials prices have rallied. However, it remains to be seen if the recent strength in commodities purchases can be maintained going forward. A couple of our indicators and market price signals are also suggesting that caution is warranted in the near term with respect to China-related plays. First, our indicators for marginal propensity to spend among households and enterprises continue to deteriorate, even when May data points are included (Chart I-11). These indicators have been good pointers for consumer discretionary spending and business investment/demand for industrial metals, as illustrated in Chart I-11. Chart I-11Marginal Propensity To Spend Is Falling For Consumers And Enterprises Marginal Propensity To Spend Is Falling For Consumers And Enterprises Marginal Propensity To Spend Is Falling For Consumers And Enterprises Chart I-12Copper: Shanghai/London Premium And Prices Copper: Shanghai/London Premium And Prices Copper: Shanghai/London Premium And Prices   Second, the copper price premium in Shanghai over London has been a good coincident indicator for copper prices and has recently been flagging short-term risks to copper prices (Chart I-12). A rising Shanghai/London copper premium implies more robust demand in China, while a declining premium signals weaker copper demand in the mainland. Finally, share prices of property developers, industrials and materials in the onshore market have failed to advance much (Chart I-13). This fact does not corroborate that there is a strong recovery occurring in China’s broad capital spending outside infrastructure. Chart I-13Chinese Stocks Do Not Corroborate A Strong Recovery Chinese Stocks Do Not Corroborate A Strong Recovery Chinese Stocks Do Not Corroborate A Strong Recovery A similar message stems from the investable universe of Chinese stocks. We are using the sector indexes from the onshore market because they are less hyped by the global FOMO rally, and the number of companies included in these onshore sector indexes is larger than in the investable indexes. Bank share prices have done even worse (Chart I-13, bottom panel). Overall, near-term risks to China-plays remain and we are looking for a better entry point in the weeks and months ahead. The trend-setting US equity market is expensive, as we corroborated in our report on EM and US equity valuations a month ago. The forward P/E ratio stands at 22, using analysts’ 12-month forward EPS expectations that we believe are still optimistic. Global financial market correlations are presently high, and domestic conditions in EM ex-China, Korea and Taiwan are rather grim. If the S&P 500 relapses for whatever reason, there is little chance EM risk assets will avoid selling off. Bottom Line: Risks are abundant and fundamentals (profits, valuations, geopolitical risks, the ongoing pandemic) do not justify higher share prices. However, if a FOMO-driven rush into stocks persists, financial markets will continue ignoring fundamentals. Investment Strategy: Momentum Is Now King When retail investors invest aggressively and central banks buy assets en masse, it is not the time for fundamental analysis. Indeed, momentum becomes king. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. Our composite momentum indicator for global share prices has risen to zero from extremely oversold levels (Chart I-14). Chart I-14Global Share Prices Are At A Critical Juncture Global Share Prices Are At A Critical Juncture Global Share Prices Are At A Critical Juncture If global and EM share prices break meaningfully above their 200-day moving averages and the US dollar breaks materially below its 200-day moving average (see Chart I-1 on page 1), our advice will be for investors to chase the rally. Even if DM and EM share prices break out, the odds are that EM stocks will continue underperforming DM ones. Hence, we continue to underweight EM in a global equity portfolio. The basis is that North Asian equity markets (China, Korea and Taiwan) are at risk of a heightened geopolitical confrontation between the US and China, as per our discussion above. Meanwhile, the remainder of EM is struggling with the pandemic. Hence, EM will continue to underperform, even if global share prices rise a lot. The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. That said, if global stocks and commodities prices break out and the greenback breaks down, we will close our remaining short positions in EM currencies and upgrade our stance on EM fixed-income markets from neutral to bullish. We have been receiving rates in Mexico, Colombia, Russia, India, China, Korea, Pakistan, Ukraine and Egypt, but have been reluctant to take on currency risk. Also, we upgraded our stance on EM credit markets to neutral on June 4. We will likely upgrade EM local currency bonds and EM credit markets further to “buy” if the above-mentioned breakouts transpire. Upgrade Chinese, Downgrade Korean Stocks Chart I-15DRAM And Korean Tech Stocks DRAM And Korean Tech Stocks DRAM And Korean Tech Stocks We are moving China from neutral to overweight and downgrading Korea from overweight to neutral relative to the EM equity benchmark. Regarding Korean equities, the risks are as follows: First, rising threats of North Korea testing a strategic weapon is negative for South Korea’s equities and currency. Second, DRAM prices and volumes are dropping. Chart I-15 shows that the DRAM revenue proxy is falling, a bad omen for Korean tech stocks that derive a lot of operating profits from DRAM sales.  Finally, the Korean bourse is heavy in old-economy stocks, which will experience a slow recovery in their profits from very low levels amid the enduring global trade downturn.  The reasons to upgrade Chinese investable stocks relative to the EM equity benchmark include: As we discussed above, the medium-term growth outlook for China is mildly positive due to the credit and fiscal stimulus Beijing has unleashed. The outlook for domestic demand is worse in many other developing economies. The credit and money bubble in China will inflate further and will pose a major challenge in the years ahead. That said, another round of major credit/money expansion will likely stabilize the system in the medium term. If the FOMO-driven mania continues, FAANG stocks will likely outperform, which will spread to similar stocks around the world. The Chinese investable index includes Alibaba, Tencent and other new economy stocks that will likely outperform the EM benchmark. If global markets correct and EM currencies drop, the Chinese RMB will appreciate relative to most EM exchange rates. This will help China’s equity performance relative to other EM bourses. Finally, if US-China tensions escalate and EM markets sell off, Chinese authorities will support share prices by deploying the national team and other government proxies to buy Chinese stocks. This will help the broad universe of Chinese stocks to outperform the EM benchmark. Chart I-16Long Chinese Investable / Short Korean Equities Long Chinese Investable / Short Korean Equities Long Chinese Investable / Short Korean Equities Bottom Line: We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Market-neutral investors should consider the following trade: long Chinese / short Korean equities (Chart I-16).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   1     Please see the following articles: Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 5India Attracts Investment As Supply Chains Diversify From China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.

Highlights Our recalibrated model suggests that, if President Trump places a 25% tariff on all Chinese goods exports to the US, then the RMB should fall by 4% against the dollar from its current value. The RMB has been trending below its “fair value” in the past two years, but as US-China tensions escalate, the PBoC will likely allow the market forces to push the RMB lower. We continue to hold a long position in the USD-CNH, but recommend investors keep the position on a short leash. The key risk to this view is a broad-based dollar weakness. So far, the yuan has been resilient against a dramatic drop in the DXY. The more that the RMB deviates from its fair value, the more rapidly and strongly it could appreciate in the absence of further tariff hikes. Feature The strong probability of a re-ignited US-China trade war this year will place the RMB under downward pressure against the USD.1 Unlike in 2019 when China was trying to reconcile with the US to reach a trade deal, this year President Trump will encounter a much less compromising President Xi Jinping. Therefore, it is more likely that Beijing will use depreciation as a countervailing tool on, and even ahead of any additional tariffs on Chinese goods exports to the US.   The RMB would likely fall by 4% if the US was to boost import tariffs to 25% on all Chinese goods. We recalibrated our Equilibrium Exchange Rate Model to project the tactical (0-3 months) fluctuations in the RMB against the dollar, in different scenarios of tariff hikes. If President Trump is to raise the tariff rate to 25% on all US imports of Chinese goods, the RMB should fall by 4% against the dollar from its current value. On a cyclical time horizon (the next 12 months), however, the RMB will likely rebound. The RMB has been trending below its fair value against the dollar since the onset of the trade war in mid-2018, but the economic fundamentals that supported the dollar’s strength in the last two years have diminished. Even if a second wave of the Covid-19 pandemic materializes, but does not result in severe lockdown measures, the dollar as a countercyclical currency will be pushed lower as global growth continues to recover. The combination of a stronger global economy and weaker dollar should help strengthen pro-cyclical currencies, such as the RMB. A Recalibrated Model Based On The Economics Of Tariffs If the US were to impose further tariffs on Chinese exports, how much will the RMB fall against the dollar? According to our recalibrated Equilibrium Exchange Rate Model, if the US was to boost import tariffs to 25% on all Chinese goods tomorrow, then the RMB would likely fall by 4% to around 7.35 against the dollar2 (Chart 1A and 1B). That said, currency markets tend to undershoot, and market forces will likely push the RMB lower on the prospect of further escalation. More importantly, the PBoC will be less likely to lean against this weakness, since the lower in the exchange rate will buffet exports. Chart 1AUSDCNY Under Tariff Rate Hike Scenarios USDCNY Under Tariff Rate Hike Scenarios USDCNY Under Tariff Rate Hike Scenarios Chart 1BA Tariff Timeline The Evolution Of The US-China Trade War A Tariff Timeline The Evolution Of The US-China Trade War A Tariff Timeline The Evolution Of The US-China Trade War Tariff hikes typically catalyze an adjustment between two countries: either in the exchange rate to realign price competitiveness, in the quantity of tradeable goods, or a combination of the two.  Chinese goods exports to the US have only modestly decreased in the past two years from the pre-trade war year of 2017. Given that global trade has been mostly slowing since then, it signifies that the adjustment has largely occurred through the exchange rate (Chart 2). For a perfectly open economy, standard economic theory suggests that the exchange rate should move by the same percentage as the tariff increase to allow markets to clear. However, both the US and China do not have perfectly open economies. This suggests that the currency adjustment needed should be smaller.3 For example, as of 2019 only 16.7% of Chinese exports go to the US. A 25% tariff on all of these exports will lift overall export prices by only 4.2% (16.7*25%). This does not even take into consideration export substitution, and/or other factors that will influence tradeable prices. Chart 2Chinese Exports To The US Did Not Drop Much... Chinese Exports To The US Did Not Drop Much... Chinese Exports To The US Did Not Drop Much... Chart 3...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency ...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency ...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency Therefore, we recalibrated our model to reflect the assumed increases in both Chinese export prices and US import prices, rather than the pure increase in the US tariff rates. We also assumed that China will bear the brunt of the costs from the tariff hikes, which appears to have been the case in the past two years (Chart 3). The projections for where the USD/CNY rate is likely to settle in the next 0-3 months have closely tracked movements in the currency since July 2018. A Cyclical View On The RMB The RMB has depreciated by about 12% versus the dollar from its peak in April 2018, a non-trivial move for a currency that has been tightly managed. Rapid depreciations in the past two years have changed the valuation perspective of the RMB. Compared with our fair value estimates, the RMB has been undervalued in both real effective exchange rate terms and against the dollar. Chart 4The RMB Is Undervalued In Real Effective Terms... The RMB Is Undervalued In Real Effective Terms... The RMB Is Undervalued In Real Effective Terms... Our revamped Equilibrium Exchange Rate Model concludes that existing tariff rates should have the USD-CNY settle at around 6.98.  Currently, USDCNY is close to 7.1, suggesting that the market has been pricing in the risk of the US raising tariffs on China.  This means in the absence of further tariff hikes, the RMB will rebound and revert towards its fair value. Moreover, the RMB in real effective exchange rate terms has been undervalued compared with our fair value estimate, which is based on China's relative productivity trends and real bond yield differentials (Chart 4). With a 10-year bond in China yielding 2.8%, versus 0.7% in the US, interest rate differentials are likely to continue to structurally favor the RMB. Against the dollar, the RMB is also undervalued based on our relative purchasing power parity (PPP) models (Chart 5). Our PPP models make two crucial adjustments for an apples-to-apples comparison. First, the CPI baskets are broken into five subcomponents including food, shelter, health, transportation and household goods. Second, we run two regressions, one using the relative price ratios of the five subgroups (regression 1), and another using an aggregated price index weighted symmetrically across both the US and China (regression 2).4 Chart 5...And Against The Dollar ...And Against The Dollar ...And Against The Dollar Chart 6The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation It is true that valuation rarely matters in the near term and the market almost always over- or under-shoots from its "fair value" levels. The strength in the USD since early 2018 has also played a dominant role in the RMB’s depreciation. However, the RMB’s spot exchange rate has deviated from its fundamental equilibrium in the past two years. In contrast with the previous cycle, the PBoC does not appear to have intervened heavily in the offshore market to prevent excessive currency weakness. For example, in 2015/2016, the PBoC heavily clamped down on outflows. Offshore HIBOR rates also spiked, which is widely viewed as the PBoC's attempt to maintain exchange rate stability and to punish speculators by dramatically squeezing RMB liquidity in the offshore market. This time around, the PBoC is taking a more “laissez-faire” approach even though the RMB is weaker than back then (Chart 6). The key message is that longer-term investors should use RMB weakness to accumulate long positions, as any tariff-related weakness will cheapen an already attractive currency. Investment Conclusions In the near-term, a flare-up in the US-China trade war could trigger investors’ risk-off sentiment and economic fundamentals could be temporarily put aside. We continue to recommend a long position in the USD-CNH. Nevertheless, the more that the RMB deviates from its fair value, the more rapidly and strongly it will reverse to its fundamental equilibrium when tensions ease between the nations. The sharp reversal in the USD-CNY spot rate in the past three weeks illustrates this view (Chart 7). Thus, we recommend investors keep the long USD-CNH position on a short leash. Chart 7CNY/USD Below Its Long-Term Trend CNY/USD Below Its Long-Term Trend CNY/USD Below Its Long-Term Trend Chart 8US Money Supply Growth Way Outpaces China US Money Supply Growth Way Outpaces China US Money Supply Growth Way Outpaces China The economic fundamentals that have supported the dollar over the past two years are evaporating. The large overhang of China’s local currency money supply may exert structural downward pressure on the RMB exchange rate.5 However, money supply in the US has grown exponentially since the onset of the pandemic and has outpaced that of China (Chart 8). Interest rate differentials between the US and China will likely widen as well. Last week’s FOMC meeting made it clear that the Fed does not intend to raise rates through 2022. In contrast, the PBoC has a track record of normalizing monetary conditions about nine months after a trough in China’s nominal GDP growth (Chart 9). Chart 9The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern There is mounting evidence that the dollar is entering a new down cycle. Aside from the Fed’s dovish stance, there is mounting evidence that the dollar is entering a new down cycle. Typically, the dollar tends to run in long cycles, of about 10-years, with bear markets defined by rising twin deficits in the US. The reason is that as the Treasury issues more and more debt to finance spending, investors usually require a cheaper exchange rate to keep funding these deficits (Chart 10). Chart 10The Dollar And Cycles The Dollar And Cycles The Dollar And Cycles Chart 11USD A Counter-Cyclical Currency USD A Counter-Cyclical Currency USD A Counter-Cyclical Currency As such, in the next 12 months, barring a second wave of the pandemic that triggers severe lockdown measures, the dollar as a countercyclical currency will be pushed lower as global growth rebounds. This should help strengthen the RMB, given the USD/CNY rate tends to move with the dollar over cyclical periods (Chart 11).   Jing Sima China Strategist jings@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1We assign a 40% probability that the US will revert to tariffs on China within the year. Please see China Investment Strategy Special Report "Watch Out For A Second Wave (Of US-China Frictions)," dated June 10, 2020, available at cis.bcaresearch.com 2As of June 15, 2020, USDCNY exchange rate is at 7.09. 3Please see Foreign Exchange Strategy Weekly Report "USD/CNY And Market Turbulence," dated August 9, 2019, available at fes.bcaresearch.com 4Please see Foreign Exchange Strategy Special Report "A Fresh Look At Purchasing Power Parity," dated August 23, 2019, available at fes.bcaresearch.com 5At around $3 trillion, China’s central bank foreign exchange reserves are equivalent to only 14% of all yuan deposits, and 11% of broad money supply Cyclical Investment Stance Equity Sector Recommendations